FIDELITY Wednesday April 23, 2008 Breakout ESession 42 John Vail, Ed.S. Kalamazoo RESA.
ADX breakout scanning - Fidelity Investments
Transcript of ADX breakout scanning - Fidelity Investments
ACTIVE TRADER • April 2010 • www.activetradermag.com 41
Spotting volatility
breakouts that are
likely to continue
can be daunting.
The Average Directional
Movement Index (ADX) — an
indicator that measures trend
strength — can help. The ADX
is unique because it can work as
a “leading indicator” that reveals
the strength of a market’s trend
before a breakout move occurs.
(For background on the indica-
tor, see “Calculating the ADX.”)
The main ADX line is typical-
ly displayed along with two
other lines — the Directional
Movement Indicators (+DMI and
-DMI) — and the three can be
used together to help reveal strong
trends. The main ADX line ranges from
zero to 100 (the higher the reading, the
stronger the trend) and usually fluctuates
between 10 and 50. Readings below 20
reflect trendless conditions — consolida-
tions that should be avoided.
An ADX above 40 indicates a strong
trend or breakout is in progress, and
price is likely to continue in the direc-
tion of the current trend. Because the
ADX measures trend strength rather
TRADING STRATEGIES
BY KEN CALHOUN
KC For more information about thefollowing concepts, go to “Key concepts” on p. 87.
• Cup formation
• Shooting star
ADX breakout scanningADX breakouts can signal momentum setups as well as exit conditions
for intraday and swing traders.
FIGURE 1: AFTER ADX > 40
Scanning charts for situations in which the ADX is poised to break out above 40 canhelp identify momentum trades.
Source: eSignal
continued on p. 42
Trading Strategies
42 www.activetradermag.com • April 2010 • ACTIVE TRADER
Calculating the ADX
The ADX is an indicator that measurestrend strength rather than direction.The higher the ADX value, the strongerthe trend, regardless of whether themarket is going up or down. The indi-cator was developed on daily data, butit can be applied to any time frame.
Although the ADX concept is straight-forward, its calculation is rather lengthy.The indicator was designed by WellesWilder and is described in detail in hisbook New Concepts in TechnicalTrading Systems (Trend Research,1978). Although it’s included in mostanalysis, it’s important to understandhow any indicator works.
Calculation
1. Calculate the positive or negative directional movement (+DM and -DM) for each bar in the desired look-back period.
Bars that make higher highs and higher lows than the previous bar have positive DM. Bars that make lower highs and lower lows than the previous bar have negative DM. If a bar has both a higher high and a lower low than the previous bar, it has positive DM if its high is above the previous high by more than its low is below the previous low, and negative DM if the opposite is true.
An inside bar (a bar that trades within the range of the previous bar) has no directional movement, nor does a bar with a high above the previous high by the same amount the low is below the previous low.
2. If a bar has positive DM, the absolute value of the distance between today’s high and yesterday’s high is added to the +DM running total calculated over a given look-back period (i.e., 20 bars, 30 bars, etc.). Similarly, if a bar has negative DM movement, the absolute value of the distance between today’s low and yesterday’s low is added to the -DM running total over the look-back period. The absolute value is used so both +DM and -DM are positive values.
3. Calculate the sum of the true ranges for all barsin the look-back period. Unlike the standard high-minus-low range calculation, true range
accounts for the gaps that can occur between price bars, and thus provides a more accurate reflection of price movement from bar to bar. True range is the greatest (absolute) distance between the following:
a. Today’s high and today’s low.b. Today’s high and yesterday’s close.c. Today’s low and yesterday’s close.
4. Calculate the Directional Indicators (+DI and -DI) by dividing the running totals of +DM and -DM by the sum of the true ranges.
5. Calculate the directional index (DX) by measuring the absolute value of the difference between the +DI value and the -DI value, dividing that by the sum of the +DI and -DI values, and multiplying by 100.
6. To create the ADX, calculate a moving average of the DX over the same period as the look-back period used in the other calculations.
Figure A shows an example of the ADX, along with the +DI (green) and -DI (red) lines. (The DI lines are typically referred to as the “DMI” lines.) The ADX line moved lower as the stock’s trading range extended in the summer of 2009, but the indicator turned higher as an uptrend established itself, especially as price gapped upward in late September. Notice the ADX peaked in mid-to-late October even though the stock continued to rally.
— Active Trader Staff
FIGURE A: ADX WITH DM
Source: TradeStation
ACTIVE TRADER • April 2010 • www.activetradermag.com 43
than direction, the ADX line will
move up sharply during sell-offs
as well as up moves.
Crossovers of the DMI lines
are not important; rather, it’s
critical to see the ADX breakout
above 40 and do so above both
+DMI and -DMI lines at the
same time.
In Figure 1 (p. 41), for exam-
ple, strong breakouts occurred
when the ADX broke out above
40 on Dec. 14 and 18. This is
the single most valuable use of
the ADX indicator: as a leading
indicator on multi-day charts to
help spot potential breakout
continuations after an ADX read-
ing above 40 occurs.
Trade entry and exit
One of the key advantages of the
ADX is its usefulness for both
intraday and swing trading. To
use the ADX for swing-trade
entries (overnight to several
weeks), look for situations dur-
ing the past two trading sessions
where it is in the process of
breaking out above 40, and the
underlying stock is also making
a new 15-day high.
In Figure 2, the ADX broke
out above 40, followed by a
bullish cup breakout confirma-
tion signal that occurred above
the $5 whole-number resistance
level, leading to a 20-percent
FIGURE 2: PATTERN CONFIRMATION
The ADX breakout was supported by a price breakout out of a cup formation andabove a whole-number price level.
Source: eSignal
FIGURE 3: MULTIPLE ENTRIES
The signal to exit the first long trade came when the ADX fell back below 40 on Dec. 15.
Source: eSignalcontinued on p. 44
Trading Strategies
44 www.activetradermag.com • April 2010 • ACTIVE TRADER
gain in the stock within two
trading sessions. Avoid initiating
new entries until after the ADX
breaks above 40, because the
trend typically won’t gain
momentum until after the indi-
cator reaches that level.
Different techniques can be
used to exit long positions,
including shooting-star candle
patterns, which are bearish
reversal signals. Set the stop-loss
just below the real body of the
candle (using a 15-minute
chart).
Another approach is to trail a
very close stop (e.g., 0.50 for
swing trades, 0.20 for intraday
trades), once the ADX starts to
reverse and move back below
40. In Figure 2, the trend
stopped shortly after the ADX
dropped back under 40 on Dec.
16, at which point the stock
consolidated for two more days.
Figure 3 (p. 43) shows an
example of multiple breakouts
occurring after the ADX broke
out above 40. In this case, the
signal to exit the initial long
trade occurred when the ADX
dropped back below 40 on Dec.
15, re-entering once it pushed
back above 40 the following day
(Dec. 16), after which the stock
continued to move upward.
To minimize stop placement, a
maximum 1.5-point stop can be
used on multi-day swing trades
in trending stocks that are con-
tinuing upward.
FIGURE 4: FOREX EXAMPLE
The dollar/yen rate moved higher after the ADX breakout above 30.
Source: eSignal
FIGURE 5: SHORT MOMENTUM
The ADX can also signal short side setups.
Source: eSignal
ACTIVE TRADER • April 2010 • www.activetradermag.com 45
Trading Strategies
Forex examples
A few minor adjustments are
needed to use the ADX indicator
appropriately in the popular cur-
rency pairs. The most important
adjustment is to consider put-
ting on a small-lot trade when the ADX
first moves above 30, then adding to
the position when the ADX breaks out
above 40. Also, use a 60-minute chart
for currency-pair trading spanning
seven days.
In Figure 4, the U.S. dollar/Japanese
yen (USD/JPY) pair moved higher in the
days following the ADX breakouts above
30 on Dec. 15. When the ADX is under
30, everything is considered “underwa-
ter;” once the ADX breaks above 30, cur-
rency pairs often finally break free of their
trading ranges for continuation plays dur-
ing the next day or two.
Because the ADX is a volatility indica-
tor, and not a directional indicator, when
it breaks out to new highs it can signal
the underlying currency pair will break
down to new lows, as shown in Figure 5.
Each time the ADX pushed above 30, the
market broke down to new lows.
Managing risk
Over-trading choppy, directionless mar-
kets results in repeated stop-outs. Using
the ADX as a scanning tool helps avoid
false breakouts and weak trade entries by
identifying the markets with the strongest
trends and highest volatility.
Breakout traders must avoid taking
trades when the ADX is trending down-
ward, which indicates consolidation. For
example, in Figure 6 the ADX trended
lower from 40 to 10 from Dec. 7 to Dec.
18, indicating it wouldn’t be a good peri-
od to trade, which was correct. Only
when the ADX started to pick up, as it
did on Dec. 21, should the stock be con-
sidered a potential trade candidate (once
the ADX breaks out above 40).
Conversely, for those who trade within
ranges — buying support and selling
resistance within a box or “channel” —
the ADX can be used to manage trades
within the range, exiting when it breaks
above 40, indicating a new trend is
established and the range is no longer
valid. �
For information on the author see p. 9.
Breakout traders
must avoid taking
trades when the
ADX is trending
downward,
which indicates
consolidation.
FIGURE 6: AVOIDING CONSOLIDATIONS
A downtrending ADX indicates consolidation — a poor environment for a momen-tum trade.
Source: eSignal
Article copyright 2011 by Active Trader Magazine. Reprinted from the April 2010 issue with permission from Active Trader Magazine. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data. 601722.2.0